What is an ETF and why should you care?

An exchange-traded fund, or ETF, is an investment that trades on a formal exchange, like a stock. Unlike a stock, a share represents an undivided interest in a pool that invests in multiple assets. For instance, the first ETF in the US was created to fully replicate the S&P 500.  As such, it theoretically invested in the 500 stocks that make up that index, and its performance was directly correlated with the performance of the S&P 500.  If the S&P 500 increases 3.8 points on a given day, so does the SPY exchange-traded fund, although the correlation is not perfect.

Advantages of ETFsWhat is an ETF?

The most obvious advantage of an ETF is that, like a traditional mutual fund, it allows for a lot of diversification for a small investment.  That diversification can be relatively narrow, such as the Guggenheim Timber ETF (CUT), which is designed to track the stocks of global timber companies and currently holds 27 securities.  They can also provide broad diversification, as exemplified by the Vanguard Total Bond ETF (BND), which replicates an index that tracks close to 8,000 bonds.  The ETF itself has nearly 5,000 holdings.

Of course, for retail investors, access to that kind of diversification has long been the province of traditional mutual funds.  So what makes ETFs different?

One of the key advantages touted by ETF enthusiasts is the fact that they trade all day long, and thus you can move in and out of positions throughout the day, just like stocks.  That contrasts with traditional mutual funds, which trade only at the end of the day.  The trading advantage also includes other characteristics that distinguish stocks from mutual funds, such as the ability to buy on margin, use limit orders, sell short, etc.

These distinctions are real, and ETFs certainly provide enhanced trading flexibility.  For the record, though, I don’t think the ability to trade in this manner is necessarily a positive thing from a behavioral finance perspective.  I will say this: if the bottom falls out of the market, and you suddenly decide that you need liquidity, selling at 10:03 a.m. ahead of additional price erosion is preferable to waiting until the end of the day to redeem your mutual fund shares.  In reality, though, that would probably be a result of poor planning more than anything.

Cost advantages of ETFs

The more important advantages, as far as I’m concerned, revolve around cost of ownership. In general, ETFs have lower expense ratios compared to traditional mutual funds, even when a direct counterpart exists. Take the case of Vanguard, a company known for its passive indexing investment products. In numerous cases, Vanguard has launched an ETF equivalent of popular index mutual funds in their lineup.  Vanguard’s version of the S&P 500 index fund carries an attractive .17% expense ratio.  The equivalent ETF, with the same holdings and the same investing mission, charges just .06%.

There are never sales loads for retail investors, although you typically pay a brokerage commission to buy and sell ETFs.  However, if you bought the aforementioned ETF through Vanguard, you’d pay zero commission.  Several of the bigger discount brokerages offer a range of free trades for designated ETFs. Of course, even when you do pay a commission it is usually very inexpensive these days.

Tax efficiency of ETFs

Exchange-traded funds are also generally more tax efficient than their traditional mutual fund counterparts.  Because they often employ a passive investing strategy, on average ETFs have much lower turnover than actively managed mutual funds.  Furthermore, in contrast to traditional mutual funds, the structure of ETFs allows them to mitigate capital gains more effectively, which means the actions of other shareholders do not have the same impact as they would with mutual funds.

In the case of traditional mutual funds, purchases and redemptions by some shareholders can cause capital gains tax implications for all shareholders.  This is not the case with smaller ETF shareholders.  If you sell your shares for a loss or a gain, you will be subject to the appropriate tax treatment of that loss or gain. However, you will likely not be subject to the same level of capital gains taxes as would be the case if you owned an identical mutual fund.  Furthermore, when a larger shareholder redeems units of an ETF and capital gains are triggered, they will likely be at a higher cost basis (less taxes) than is the case with a mutual fund.

The technical details behind the tax treatment of ETFs and mutual funds are probably better left to a separate post.  The key takeaway is that ETFs will generally be more tax efficient than even a mutual fund with the same holdings and trading patterns.

ETFs and enhanced transparency

While mutual funds only report their holdings at the end of each quarter, typical, plain-vanilla ETFs generally communicate their holdings on an ongoing basis. Among other things, this sidesteps the potential for window dressing.

Window dressing comes in multiple shapes and sizes, but in brief it entails hiding the holdings of a fund by selling just before a reporting period ends and buying something that looks more attractive.  For instance, let’s say a mutual fund maintains large holdings in several stocks that performed poorly over a given reporting period.  Furthermore, one or two of those holdings lose value in a very public way, much like Sears Holdings just dropped about 20% when it reported that it had a poor holiday season and will now close up to 120 stores.  Rather than face the music and defend why he maintained a big position in the underperforming holdings, a fund manager may just sell out of those positions and buy a stock that performed very well over the period in question. Consequently, it looks like the fund was well-positioned during the quarter, and the manager has a knack for identifying good investments.  Theoretically, money would flow to that fund as a result.  Of course, your overall investment in the fund would not miraculously increase with this sleight of hand.  In fact, a careful observer would be forced to wonder why the fund didn’t perform better, given its positioning.

The practice of window dressing is not possible if holdings are being reported on an ongoing basis, as is the case with the average ETF.  To a much greater degree than is the case with mutual funds, ETF investors know what they’re getting when they make a purchase.

Important note:  the ETF transparency issue is less black and white than is commonly assumed.  That is probably a topic for a future post, but for today’s purposes, the transparency that is relevant here pertains to the simple, plain-vanilla ETF that tracks an index and is meant to be a passive investment.  There is a large and growing universe of more esoteric and leveraged ETFs that play by different rules.  That IS a topic for a future post.

About Kevin O'Reilly, CFP®

Kevin O'Reilly, CFP®, is a financial advisor who specializes in working with parents of twins and triplets. Have a financial question? Ask Kevin!

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